Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Community Health Systems, Inc. (NYSE:CYH) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Community Health Systems's Net Debt?
The chart below, which you can click on for greater detail, shows that Community Health Systems had US$13.4b in debt in June 2019; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.
A Look At Community Health Systems's Liabilities
According to the last reported balance sheet, Community Health Systems had liabilities of US$2.50b due within 12 months, and liabilities of US$14.9b due beyond 12 months. Offsetting these obligations, it had cash of US$207.0m as well as receivables valued at US$2.49b due within 12 months. So its liabilities total US$14.7b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$380.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Community Health Systems would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Community Health Systems shareholders face the double whammy of a high net debt to EBITDA ratio (9.9), and fairly weak interest coverage, since EBIT is just 0.79 times the interest expense. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Community Health Systems actually grew its EBIT by a hefty 314%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Community Health Systems's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Community Health Systems actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
To be frank both Community Health Systems's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Healthcare industry companies like Community Health Systems commonly do use debt without problems. We're quite clear that we consider Community Health Systems to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given the risks around Community Health Systems's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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